Opinion: Field of Dummies and The Greater Fool Theory

By chance, I was on three continents in the last month (US, Europe, and Asia), and strangely, investors in all three were struggling with the same issue:  the damaging effect of currency moves, especially a rising US dollar, on their portfolios. Even more disconcerting for me, as someone who entered the pension business in 1995 because the CIO of the World Bank Pension Fund was concerned about massive checks being written on the passive currency hedge as the US dollar collapsed, is that, 23 years on, many funds globally still assume that the strategic hedge ratio is equivalent to no view on currency, and also assume it to be a static hedge ratio.

In the US, many funds have invested abroad on an unhedged strategic basis and this decision embeds the implicit view that the US dollar will be weak. Portfolio returns will be impacted negatively when the US dollar is strong and it is usually implicit views that are pernicious to robust returns. European regulators take the view that fully-hedged global exposures are the “safe” option, and hence most European plans are hemorrhaging cash because full hedging with a rising US dollar is risky. Again, the implicit view is that the Euro will be strong, which is being tested today.

European funds had the same experience in 2008, but do not seem to have learned from that experience. As a bond/swaps trader and an academic wannabe, nudged into the pension business somewhat suddenly by the collapse of the US dollar in 1995, I made two naïve recommendations, which could still help pension plans globally today: first, set the strategic hedge ratio based on asset-liability considerations, but manage it dynamically (just like one should manage portfolio beta dynamically); and second, since all my bank counterparts had large proprietary currency (or FX) trading desks using their own capital, and these institutions were clearly not dummies, there was probably money to be had in managing currencies actively.

It is fascinating that the two principal risks in portfolios, beta and currency, accounting for say 75% and 15% of portfolio risks, respectively, are managed on a static basis by a majority of funds globally, and all the focus is on selecting managers who probably account for the residual 10% of risk. An earlier column  argued that innovative investors could boost total returns by as much as 1% to 1.5% p.a. on the entire fund, with no change to policy or manager line-up, by managing beta dynamically within board approved ranges. I will go further and argue that managing currencies dynamically/actively could add an additional 0.5% to 0.75% p.a. on the entire fund – not a shabby contribution to total returns when typical forecasts of expected returns of portfolios are languishing in the 7% range. This follows because a 25% allocation to international assets, earning 2% to 3% from intelligent strategic and active currency positions, delivers 0.5% to 0.75% p.a. (of uncorrelated returns) on the entire fund. The simple solution I offer here is to “FiX” the currency management in portfolios for this additional return pick-up.

At the World Bank, we had two basic rules that had to be met before we decided to be active in a particular investment area, quixotically expressed as: (a) Find the Dummy; and (b) The Greater Fool Theory. Currency satisfied both. “Find the Dummy” essentially argued that in a zero-sum business such as investments, you needed to find the “dummy” who was willing to lose money so that we could capture it. If we did not find the dummy – it was us! In equities and bonds (or even the latest craze, risk-premia), with everyone trying to make money, the dummy was hard to find and hence it was probably sensible to be passive rather than active (unless the benchmark/regulations caused some quirks). In currency, since it was a medium of exchange and not a pure asset, many individuals and institutions (corporations, asset managers, central banks) buy and sell FX to engage in transactions, not necessarily to profit from the currency trade. One could call currency land the “Field of Dummies,” using the term “dummies” loosely, as probably a majority of trading is for non-profit activities. In many cases, institutions transact in currencies without regard to valuation, thereby providing opportunity for more active programs.

More interestingly, consider the simple scenario of an international equity manager that believes that the Japanese yen is going to depreciate significantly thereby making Sony Play Stations very cheap for our children. This international equity manager, wanting to buy Sony, would convert a US pension fund’s assets from US dollars to yen, and buy Sony stock in Japan. But in holding yen along with Sony, they made a potentially terrific equity trade but a dreadful FX trade because the yen was expected to weaken. The reason they could get away with this terrible currency trade is that the US pension fund held them accountable to an unhedged currency benchmark (implicitly expressing the view that the US pension fund believed that the yen would be strong). The example of currency dummies could go on endlessly, including my own naïve currency trades at the various ATMs on this jaunt, despite the fact that my own FX models told me otherwise.

The Greater Fool Theory went along similar lines – again, in a zero-sum game of investments, if an investor felt they were good at selecting active managers, they had to believe there was some other investor/chief investment officer, who was a greater fool and would hire a bad performing manager. In a “Field of Dummies” (much like in the case of beta management), the asset owners who either did nothing or hedged passively (or rebalanced passively) were lending their balance sheet to the active management community. Hence, better to be a smart investor, than a naïve rebalancer throwing up alpha for others to exploit.

Now all is not golden in the Field of Dummies. After leaving the World Bank in 1999, I headed up FX research for JP Morgan Asset Management, and then worked at FX Concepts – at one time the largest currency hedge fund before imploding to zero. The creation of the euro and the synchronization of central bank policies globally, not only took many currencies off the table (no more Spanish peseta, Portuguese escudo), but also made it harder to manage traditional currency programs. Before leaving the FX space in 2006 to focus on managing beta, I wrote a paper with a colleague, Harish Neelakandan, titled, “Don’t Be Grumpy because your Currency Returns are Lumpy” – which my kids will probably sue me for someday. The premise of the paper was simply that if you lose currencies when you create a super currency like the euro, then the only way to improve active currency returns was to add new instruments, like options. Very simply, they provide alpha (again, think about naïve hedgers being the dummies) and give many more “options” to diversify risk (as you can pick maturity, strike etc.). In talking to pension clients recently, the experience with active currency managers seems to be average over long cycles, and few of these managers have adopted currency options as a staple of their currency programs, thereby probably explaining the mediocre result. Further, negative interest rates made things weirder than one could imagine.

So, what’s a potential FiX? The current regime in 2018 is unique in that there is potentially policy divergence and the years of quantitative easing have created unusual opportunities. First, the US central bank appears to be on a sustained path to raising rates; other central banks in the developed world are more circumspect. Moreover, most emerging markets are reeling under the strong dollar and the first half of 2018 has demonstrated how vulnerable emerging market investments are to dramatic depreciations in currency (e.g., China, Turkey, Argentina, India). There are two levers in currency investments – the strategic hedge and whether to implement it passively/actively.

One of the fascinating aspects of currency markets, and a potential source of alpha for most currency managers, is the fact that, contrary to economic theory, in developed markets, high (low) interest rate currencies tend to appreciate (depreciate). This strategy, called the “carry trade,” as it captures the interest rate differential between borrowing in one currency and lending in the other, tends to work over long cycles when markets are “risk-on,” with short-term reversals when markets are “risk-off.” Therefore, one of the simplest ways to manage the strategic hedge intelligently and dynamically is to calculate the interest rate differential between the base currency (say, US dollar short rates) and, for example, an EAFE weighted basket of the same maturity interest rates. If the carry is negative (i.e., the base currency rate is too low), then the asset owner should consider leaving exposures unhedged to benefit from the base currency depreciation. Similarly, if the carry is positive, then the asset owner should consider hedging the exposures, with potentially the size of the hedge being linked to the magnitude of the carry. This simple rule will add meaningful alpha at low cost, but since it can have big drawdowns, it could be complemented with a simple momentum-rule.

However, having been an asset owner and seeing how, in many cases, the governance structure is not conducive to staff taking decisions internally, the second lever is to engage a mix of active currency managers, which is more expensive and time consuming. Currency managers come in different flavors: qualitative, quantitative – fundamental, quantitative – technical, volatility-based etc. Once again, currency markets tend to offer alpha for simple ideas (e.g., currencies trend; high inflation currencies tend to depreciate), but putting together a diversified mix of strategies and instruments (forwards, futures and options) are the keys to success. And finally, be patient and take the long-term view that every asset owner should. Don’t be grumpy if your currency returns are lumpy as the patient investor will be rewarded by the field of dummies.

Tags: Arun Muralidhar, currency, currency hedge, field of dummies, FX, interest rate